Good Debt and Bad Debt Differences: What You Should Know
The word “debt” has all kinds of negative connotations — and with good reason. Carrying a heavy debt load not only jeopardizes your financial security, but it can also lead to everything from marital problems to health issues.
That hasn’t prevented Americans from piling up the debt, however. During the 2023 second quarter, combined credit card debt in the United States surpassed $1 trillion for the first time, CNN reported, citing data from the Federal Reserve Bank of New York.
High inflation has contributed to the recent rise in credit card debt, but so has a post-COVID increase in consumer spending. No matter the cause, escalating credit card debt will likely give nightmares to financial experts who strongly advise against running up card balances.
Given the nature of economics and personal finances, it’s all but impossible to avoid debt completely. But you can do yourself a big favor by learning the differences between “good” and “bad” debt.
As Rocket Loans noted in a recent blog, debt that can directly benefit the borrower can be considered “good debt,” while debt that negatively affects the borrower’s life and finances is “bad debt.”
Here’s a look at the differences between good and bad debt.
Good Debt
One sign of good debt is that it can be used to finance something that will offer a good return on the investment, according to Equifax. Here are some examples:
Mortgage Loans
Buying a house is considered one of the best financial moves you can make because it provides a place to live while also letting you build equity in a potentially profitable asset. These benefits alone make taking out a mortgage “a good form of debt,” according to Rocket Loans. As an added bonus, in some cases you can deduct your mortgage’s interest from your income taxes.
Student Loans
The most obvious benefit of a student loan is that it finances an education that can help you advance your career and earn more money. In many cases you can get very low rates on student loans — especially with federal government loans — and you might not even have to pay them back if you qualify for certain forgiveness programs. Just make sure that the loan is paying for a good education from a reputable college.
Small Business Loans
If you own a small business or even have a thriving side hustle that can use more capital, small business loans can help you grow your operation, leading to greater sales and profits.
Auto Loans
Most people need a car to get to and from work, run errands, drop the kids off at school, and handle other chores. Because cars are so expensive these days, paying cash for one is not a viable option for the vast majority of Americans. Car loans provide a way to get access to needed transportation. Ideally, your credit score will let you get the lowest possible annual percentage rate on your car loan because otherwise you might be paying a high rate for several years.
Bad Debt
Equifax describes bad debt as something you are “unable to repay” and is used to finance purchases that don’t provide a good return on investment. Here are a couple of examples:
Credit Cards
There’s nothing wrong with having credit cards — in fact, they can help your credit score by boosting your credit history and improving your credit utilization ratio. The problem is that they also carry very high interest rates (often 20% or higher) and can “cost you more in the long run if you can’t make your payments every billing cycle,” according to Rocket Loans. Depending on credit cards to make numerous large and inessential purchases can quickly put you under a mountain of debt that might take years to crawl out of.
High-Interest Loans
These might include payday loans or unsecured personal loans and are almost always a bad idea. As Rocket Loans pointed out, payday loans typically must be repaid by your next paycheck, their APRs can be as high as 400%, and you might face fees ranging from $10 to $30 for every $100 borrowed.
The best thing you can do to stay out of bad debt is to avoid getting into it in the first place. Experts recommend avoiding expensive purchases you can live without – especially if you can’t afford to pay them off quickly. If you have to borrow money, keep it to amounts you can afford. Finally, build an emergency fund that lets you cover unexpected expenses with cash rather than a credit card or loan.
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